March 15, 2015

An Exploration in the Deep Corners of the Oil Market

Oil prices have dropped dramatically focusing the attention on the short run. This article takes a longer view. It argues that the oil market is shaped by forces pertaining to demand and supply. A simple model integrating these forces is presented as a useful tool to explore likely scenarios. Notwithstanding the level of uncertainty surrounding the evolution of both demand and supply forces, simulations point to the emergence of supply shortages suggesting that available forecasts predicting persistently low oil prices may be too optimistic. 

Oil prices have fallen by over 50 percent since June 2014. Much has been writ- ten about what triggered this slump, and the relative role of supply and demand factors. Considering that price elasticities are extremely low in the short run, disturbances, such as the shift in strategy by OPEC, can result in sharp fluctuations in prices. Simple extrapolations of recent trends would give a very misleading picture of future oil prices over the longer term. The long-run price elasticities are considerably higher, as both consumers and producers change their behavior, and adopt new technologies, and underlying developments in demand and supply come to the fore. While there is uncertainty about the evolution of these developments, there are known elements such as geology on the supply side and demographics on the demand side. Technological innovation, responding to economic incentives (e.g., the advent of shale exploitation), and to policies aimed at reducing greenhouse gas emissions (e.g., the emergence of alternative energy sources) also will play a key role in shaping the oil market.

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